Why Bad News Is a Good Thing

We’re guessing that the bulls are probably feeling pretty good about themselves right about now. After a week that started off with yet another scary dive of -9% on Monday and more bad economic news than you could shake a stick at during the rest of the week, things actually finished up fairly nicely as the closing bell rang on Friday.

While it was nice to see a minor melt-up into the close Friday afternoon, we are really talking more about the tone of the market than the actual price levels themselves. In short, the fact that stocks did not continue to dive after Monday’s plunge was itself a positive. And from a technical perspective, the bulls can take solace in the facts that (1) the recent support zones held and (2) volume increased into Friday’s ramp.

But in looking back, after Monday’s thrashing, few would have projected the semi-happy ending we enjoyed this week. Although traders came into the week feeling like the market had finally turned the corner, the big drop coupled with an unrivaled batch of bad economic news could have sent the few bulls left in the game back into their fox holes.

An Abundance of Bad News

While the news flow was exceptionally negative all week long, Friday’s jobs report was the icing on the cake. The Bureau of Labor Statistics reported that Nonfarm payrolls fell by a jaw-dropping 533,000 jobs in November, which was well beyond the consensus for a decline of 350,000. Statistically, it was the biggest decline since December 1974. And when you look at the numbers on percentage basis, it was the most since May 1980. In addition, the prior two months were revised down by an eye-opening 200,000 jobs. Finally, for those of you keeping score at home, the economy has lost 1.9 million jobs since the recession began, with two-thirds of those losses occurring in the last three months.

The other highlight (or in this case, lowlight) was the declaration by NBER (the National Bureau of Economic Research) that the economy was indeed in a recession – and has been for the past year. The NBER is a private, nonprofit outfit that is the official keeper of the dates that expansions/contractions start and stop for the U.S. economy. While most analysts use two consecutive quarters of negative GDP growth as the definition of a recession, the bottom line is the NBER says that economic expansion ended in December 2007.

Although we fully recognize that bringing up even one more economic statistic may induce a mass clicking of the delete button, there was one other bit of data that bears reiterating this weekend. While it got little to no play in the popular press, the ISM’s (Institute for Supply Management) Manufacturing Composite (formerly the Purchasing Managers Index) for the U.S. tumbled to a 26-year low in November.

While this wasn’t exactly cheery news, it was the PMI reports from around the globe that really got our attention. In running down the numbers, we can see that the PMI projects a contraction in the manufacturing sector just about everywhere around the world (a reading below 50 indicates contraction). And in short, this is a clear indication that the rest of the globe is going to be joining the U.S. very soon in announcing they are in recession.

Global PMI Indices Country PMI Reading U.S. 36.2 U.K. 34.4 Euro-Zone 35.6 Switzerland 35.2 China 38.8 Russia 39.8 Hungary 39.9 Poland 40.5 South Africa 39.5 Readings below 50 indicate contraction in the manufacturing sector. Source: Ned Davis Research

Now For the Good News

The good news is that all of the bad news is actually normal for this point in the cycle! While this may sound counterintuitive and hearing the dour data day after day may cause you to don the crash helmet and hide under your desk, it is important to recognize that the news flow does NOT indicate that things are going to get worse.

Remember, the data that is being released is of the rear view mirror variety. And frankly, everybody already knows that the economy fell off a cliff in September/October. So, given that (1) the stock market has already discounted this via a decline of -42% from September 1st through November 20th and (2) the current bear market sports the biggest decline since the bear of 1937-38; it is a fairly safe bet that the market has either fully discounted, or is darn close to discounting anything and everything short of the Great Depression.

Using History as Our Guide

With the caveats that what we’re about to discuss is anything but an exact science and the historical sample size is relatively small, looking back at history provides us with a glimmer of hope going forward.

In looking at the timeline of when recessions are announced in relation to when they actually began, we see that the official announcement from NBER that the economy is in a recession means that the recession is actually fairly close to ending. Looking back at the last five recessions, we find that a recession has, on average, already been in place a full seven months before the NBER announcement was made (this time it has been 12 months) and that the actual end of the recession typically comes just 4 months after the official pronouncement.

When you overlay the S&P 500 on the recession timeline, we find the following. First, stocks typically begin to discount a recession in advance of the recession – in this case the bull market peak occurred three months before the economy entered the contraction. Next, we see that stocks typically enjoy a minor bear-market rally in the two months following the official word from NBER. And then from there, stocks encounter a series of fits and starts – including a new low – before ultimately embarking on a new bull market about eight months after the recession announcement has been made.

Cutting to the Chase

So, cutting to the chase, if history repeats, we can expect a modest rally into year-end which, unfortunately should be followed by a new low into January/February. This low will likely be caused by some additional bad news that scares the last lot of sellers out of the market. And in this case, we could argue that this event would coincide with the final redemptions from the hedge fund community.

But, from there, stocks could embark on a meaningful rally, which will bring hope back into the equation. And although this falls into the speculation category, if history is our guide, this is a rally that could be worth pursuing.

So, how does one play the current market? For starters, each individual must define their time frame. If you are short-term in your approach, you should be attempting to “ride the range” here. You should be watching the short-term resistance levels at 900 on the S&P 500 and 8830 on the Dow VERY carefully